A year on from the collapse of several regional U.S. banks, a new fear emerges: mounting losses on real estate loans.
Despite the hard realities, there’s also a fair dose of hyped exaggeration at play. The U.S. banking system is healthy and able to weather the likely volatility ahead.
The core business of banking is easy to understand: Deposits are turned into loans, loans generate cash flows, depositors are repaid, and the whole cycle starts up again.
The picture is a little more complicated with stock and bond investors included, but not by much.
So where lies the issue ? This round of 
falling regional bank stock prices comes amid concerns on banks’ exposure to commercial real estate (CRE), particularly office and retail properties that have been negatively impacted by changing work and shopping habits.
Problems: Yes. Catastrophe: No
Losses are real, and the impact will be felt. However, there are huge differences between the events of 2008, for instance, and reasonably likely outcomes for banks today .
It is very unlikely that large banks will be stressed. The solvency of the overall banking system is not a concern. Instead, we are likely to see stress in some smaller banks, as rising credit losses could force capital raising that would, in turn, pressure security prices. Moreover, it would not a shock to see larger, well-capitalized banks acquiring CRE-troubled lenders at discounted prices.
This is not “business as usual,” but is instead “resolution as usual.” Any problems in small banks largely dealt with by the normal capitalist process of resource reallocation.
CRE is a meaningful problem. Projects are closing and properties are being sold well below recent appraised levels. Bank lenders, who are typically the first in line for repayment, are almost certainly going to do better than project developers and junior lenders, but “better” is different than “good.”
According to the National Bureau of Economic Research (NBER), U.S. banks overall hold approximately $2.7 trillion in CRE loans. Not only is the size of CRE exposure an issue for banks, but it’s also fundamentally different than the financing issues that hit regional lenders last March.
After Silicon Valley Bank’s (SVB) failure, the need was to fund good assets as depositors left. That’s the textbook reason central banks exist, and the Federal Reserve provided the necessary loans to calm the waters.
Last year, we pushed back on the idea that there was a crisis largely because the solution was obvious and easy to implement.
Post-SVB, bank failures were a policy choice, not an economic requirement. This time around, though, we are not dealing with an easy-to-solve funding mismatch, but a real problem: allocating the losses on loans that have gone bad and where the bank will never recover the full amount of the original loan.
A well-reserved and capitalized bank in the U.S. will have equity to cover a loss of around 10 % of its assets—some have more, some have a little less. Even in a recession, that’s usually plenty to deal with credit losses, but unexpected stress can quickly make the math look challenging.
If a relatively trivial 3 % of assets are tied to the most problematic office loans, for instance, a simple calculation shows that nearly 25 % of a bank’s capital could be at risk in a scenario of widespread defaults and low recoveries. Any institution facing those kinds of losses would likely be forced to cut dividends and take other measures to shore up its balance sheet and appease regulators.
Critically, though, we think a bank in that position should still be solvent—we’re discussing deep wounds, not necessarily fatal ones.
Despite the real problems in the sector, there is also a fair dose of hyperbole.
CRE is an incredibly broad label, covering everything from cold storage facilities to apartment buildings. The current set of concerns is focused on three primary loan types:
- Office space
- Retail
- Multifamily housing
But even within this set of assets there is huge variation in the likely outcomes between individual properties.
The $2.7 trillion figure from NBER is a theoretical maximum exposure; the practical risk in the banking system is a small fraction of that amount. Importantly, the risks on the largest loans have been distributed through securitizations and other transfer mechanisms.
Outside of specialized funds, very few investors that we are aware of have large allocations to the most troubled CRE sectors. This reduces— even if it does not necessarily eliminate—the pressure to sell assets at deeply discounted prices. The odds of contagion, where losses in one sector lead to forced selling in other markets, would ultimately be reduced.
For the banking system overall, there very likely sufficient capital to absorb a complete write-down of the entire $2.7 trillion in estimated CRE exposure, although that would leave it essentially drained of equity. The issue, of course, is that the allocation of capital does not necessarily match the allocation of likely losses.
This problem is particularly acute at small lenders, as they are the major players in the CRE space. According to the NBER, banks with less than $1.4 billion in assets account for about $419 billion of the banking system’s exposure; this corresponds to about 25 % of smaller bank assets. In absolute terms, the largest banks—those with over $250 billion in assets—have greater CRE exposure, but it amounts to less than 5% of their overall investments, according to NBER data.
Small banks’ reliance on CRE is a double hit.
Not only are they seeing large write-downs on existing loans, but pressure from investors also makes it difficult to aggressively originate new loans, reducing earnings and making it more difficult to replenish the coffers. Larger banks, by comparison, have diverse revenue streams
and the impact of diminished CRE lending is, on average, barely noticeable.
One bright spot we see for these banks is that after last year’s depositor flight, there’s reason to believe that remaining depositors are stickier and may stay with the bank despite negative headlines.
A final issue, particularly for community banks, is loan concentration. Average loan sizes in the CRE world are much larger than in retail banking, so even a few problem loans can have a meaningful impact on the results and capital of a small bank.
Despite the realities and the risks, widespread bank failures from CRE exposure remain unlikely. Rising losses on CRE loans cutting into capital levels, while more expensive funding and reduced lending opportunities serve as a headwind to earnings. This may lead to some bank failures, but we do not foresee anything that would unduly stress existing mechanisms to resolve troubled banks.
The largest banks, by contrast, will likely do fine in any CRE pullback, as their lower exposure and cheaper funding allow them to take advantage as opportunities arise.
The U.S. banking system is healthy and will likely be able to weather the likely CRE volatility ahead.
As always, if you have any questions or comments, please feel free to reach out.